Franchisors Can Shield Disclosure of Parent Company Financials, Says LeClairRyan Attorney

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But alternative approaches to FDD disclosure must be carefully considered, warns veteran franchise attorney Thomas M. Pitegoff

Tom Pitegoff

If the franchisor wants to avoid disclosing parent company financials and protect it from liabilities of the franchise subsidiary, the simplest approach is to be sure that the parent does not perform any post-sale obligations

Franchisors selling franchises in the U.S. may have some options to avoid including their parent company’s audited financial statements in Item 21 of the Franchise Disclosure Document (FDD), but the company structure should be carefully considered, warns Thomas M. Pitegoff, Senior Counsel and co-chair of the franchise industry team of national law firm LeClairRyan.

The audited financial statements of a franchisor must generally be disclosed in the FDD for U.S. offerings, writes the New York-based Pitegoff in a recent blog, When are Parent Company Financial Disclosures Required? His post appears in the firm’s Franchise Alchemy, which focuses on franchise law, franchise agreements and related issues.

“But if a franchisor does not want to do this, the parent-company financials can be used instead,” Pitegoff explains. “This is easily done when the parent company is a public company that already has audited financials. But most franchisors are not public companies, are not likely to have parent-company audited financials, and would prefer not to incur the added expense of auditing a group of companies instead of just the franchisor entity. The franchisor may also want to shield its parent company from liability to franchisees.”

Still, the Federal Trade Commission Franchise Rule requires parent company financial disclosures in certain cases, including if the parent “commits to perform post-sale obligations for the franchisor or guarantees the franchisor’s obligations,” Pitegoff notes. “So, if the franchisor wants to avoid disclosing parent company financials and protect the parent from the liabilities of the franchise company subsidiary, the simplest approach is to be sure that the parent does not perform any post-sale obligations of the franchisor to the franchisee.”

To do this, a franchisor could ensure that any such post-sale obligations—including supplying specified equipment, goods, inventory or services to franchisees—are performed by the franchisor itself or an affiliated company.

Parent company financials are also not required when an affiliate is the supplier and the affiliate does not guaranty the obligations of the franchisor. “For this reason, many franchisors will have a holding company that owns both a supply company and a franchisor entity, as well as an operating company that owns the ‘company’ outlets,” explains Pitegoff. “These are affiliated companies or sister companies.”

Many new franchisors form a new entity to be the franchisor, rather than the company that has been operating the business through company-owned locations. In this case, the first FDD can include an audit of the newly-formed franchisor’s opening balance sheet. In most states— but not New York—the opening balance sheet may be unaudited.

A franchisor that prefers to not disclose its own financials has another option: including financial statements of an affiliate, if the affiliate “absolutely and unconditionally guarantees to assume the duties and obligations of the franchisor under the franchise agreement.” But a franchisor taking this approach still has to disclose the financials of its affiliate or its parent company.

In any case, avoiding disclosure of affiliate company financial statements does not mean that no financial disclosures of affiliates are required. The FDD still requires disclosure of required purchases from the franchisor or its affiliates. This includes disclosing the total revenue, revenues from all required purchases, and the percentage of total revenues that the franchisee or its affiliates receive from required purchases. This is a meaningful disclosure, but far less comprehensive than audited financial statements of the affiliate.

Aside from the financials, other affiliate disclosures are required in the FDD’s Item 1 (the franchisor and any parents, predecessors and affiliates); 3 (litigation); and 4 (bankruptcy). Further, Items 5 (initial fees), 6 (other fees) and 7 (estimated initial investment) require disclosure of payments that must be made to affiliates. Finally, Item 20 (outlets and franchisee information) requires disclosures of the numbers of “company” outlets, which may actually be those of an affiliate.

“Completing the franchise disclosure document is a complicated, yet necessary part of the franchising process,” Pitegoff counsels. “A legal advisor who knows the franchisor’s objectives can help to make the process as painless and smooth as possible.”

About LeClairRyan
As a trusted advisor, LeClairRyan provides business counsel and client representation in corporate law and litigation. In this role, the firm applies its knowledge, insight and skill to help clients achieve their business objectives while managing and minimizing their legal risks, difficulties and expenses. With offices from coast to coast, the firm represents a wide variety of clients nationwide. For more information about LeClairRyan, visit http://www.leclairryan.com.

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Bill Parness
Parness & Associates
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